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Civil Litigation Solicitors

An Introduction to Islamic Financial Instruments: Mudarabah (14 December 2020)

Date: 14/12/2020
Duncan Lewis, Civil Litigation Solicitors, An Introduction to Islamic Financial Instruments: Mudarabah

The precarious environment of the current economy may cause a person to search for methods of self or business financing separate to the current financial techniques predominantly used in the finance sector. Islamic finance, on its principles, presents such an alternate through its foundations which include; social mobility; wealth distribution for a fairer economy; and using money as a vehicle for economic stability and societal prosperity. Such foundations are deduced through Islamic teachings and principles.

Explanations and examples of an instrument used in Islamic finance - designed to achieve the above outcomes – are detailed below:


Mudarabah

Mudarabah is a type of contract and Islamic financing instrument which allows for funds to be provided to a party seeking an investment. One party provides labour or expertise (Mudarib) and the other (Rab El Mal) provides capital (derived from Sharia compliant means). Though the money will be paid back to the investor at the successful completion of the contract, it is different to a conventional loan as there can be no interest, which is prohibited in Islamic finance. An agreed split of profits can be determined at the outset of the contract, which will be the split after the taxes and expenses. This will be a pre-agreed ratio and cannot be a pre-agreed sum. Further, at the end of the contract, the capital is repaid, but whatever is owned by the Mudarib will not be owned even partially by the Rab El Mal, and the Rab El Mal has a complete lack of operational control of the venture at any time. Both parties must be of sound mind and a healthy disposition.

A performance guarantor may be provided for the Mudarib, who will only be to carry out the labour or venture which the Mudarib had set out to do if not completed. However, the guarantor will not need to pay the money back. If the venture fails, the investment will generally be lost. There are ways however, in which the Rab El Mal will be able to be compensated for the lost capital. If the Mudarib has been either reckless, negligent or fraudulent, and this has caused the loss of capital, then the Mudarib will have to pay back the capital to the Rab El Mal.

There are also different types of Mudarabah contracts; a restricted Mudarabah contract, where certain limitations are placed on the method in which the venture is sought at the beginning; and unrestricted – where there are no such restrictions. In the event the Mudarib pursues something which is not specified in the contract and as a result the capital is lost, the Mudarib will have to compensate the Rab El Mal. The Mudarib will also have a duty to mitigate his losses. In any of the above circumstances, the Rab El Mal would have the right to pursue the Mudarib in court, the burden of proof being on the Rab El Mal to prove that the Mudarib beached the contract.


Projects

This type of financing technique is well suited for investment, such as infrastructure and/or projects involving entrepreneurs and projects where funding from large financiers can be secured. With large scale projects, the bank can act as both a Rab El Mal and a Mudarib, which would give rise to a two-tier Mudarabah contract, by way of two separate contracts. The bank would be the Mudarib, in the contract with a financier, and the financier would be the Rab El Mal, but in the contract with an entrepreneur/investee, the bank would be the Rab El Mal and the entrepreneur would be the Mudarib.

Banks can be effective Mudaribs, as it is unlikely they will lose all capital as Mudaribs and therefore can be returned in full to the Rab El Mal at the end of the contract, and they also have the capability of spreading their investments out on projects as a Rab El Mal. A bank also has the capability of being able to secure capital from large scale investors i.e. hedge funds, and using this capital to invest in entrepreneurial projects.


Example

An example of how a Mudarabah contract has worked effectively can be seen by the Sudanese Abu-Halima Greenhouses Project of IRADA, a micro-finance company set up and promoted by Bank Al Khartoum, the largest bank in Sudan.

This is a project which was designed in 2011, funding micro-entrepreneurs, with the objective of addressing several critical social issues. The bank used a restricted Mudarabah contract, providing the Mudaribs with non-financial services, as well as the capital necessary, to partake in the project such as technical training, managerial and marketing support. The restrictions in the Mudarabah contract related to financing of working capital, the supporting of infrastructure, technical feasibility and agricultural input. As an example, to be eligible, one of the conditions was a financial cap on each household participating, of $32,000.00.

The only other security required, aside from the usual tenets of a Mudarabah contract, was a personal guarantee against mismanagement and lack of commitment. Losses were taken by the bank, and profits would be shared in the profit ratio of 40% for the micro-entrepreneur and 60% for the bank. Profit distribution would take place twice in a year for five years. However, at the end of the five years, once the entrepreneurs had been adequately trained, they would retain 100% of the profits - essentially owning the venture. Bank Al Khartoum was funded by the Ministry of Finance, the State Ministry of Agriculture, the Ministry of Social Affairs and Sanaa food hyper-mart in this venture and therefore the whole project was based on a two-tier Mudarabah contract.


Applicability

Islamic finance currently plays a role in UK infrastructure, and has been involved in funding projects such as The Shard, the Battersea Power Station Regeneration and the redevelopment of the Chelsea Barracks, amongst others. Given that there has been an increase in the UK in recent years to fund infrastructure projects by Islamic finance it seems viable that a method such as the example used above, may well suit the UK market. Another reason for this is the range of supportive government supportive policies (The Finance Acts 2003 - 7) over recent years.

Under UK law, an investor should be entitled to repayment of the capital sum if lost by a bank; therefore, this allows banks to offer Mudarabah contracts compatible with UK law regarding deposit-taking. The Financial Services Compensation Scheme (FSCS) also assist in this endeavour as they can protect an individual of up to £85,000.00 at first instance.

Mudarabah contracts may be considered as an alternative method to existing similar financing methods, such as venture capital. This is especially true when considering their comparable abilities to assist in creating innovation, financing projects concerning entrepreneurship, start-ups and small companies, as well being able to create innovation - creating growth and improving the UK economy. In consideration of Islamic financing techniques’ ultimate objectives, summed up as a fairer society through a fairer economy, there is clear room for Mudarabah financing to become more prominent within the UK financial sector.

Law in this this area can be tricky as everything must be yielding to Sharia law, and concurrently be acceptable by domestic laws - accordingly - the advice of a lawyer may be required to ensure such compliance.


Author Ammar Sotta is a solicitor in the Civil Litigation team at Duncan Lewis Solicitors. He handles a wide range of litigation matters including commercial and civil litigation claims, commercial disputes, disputes arising under a contract, misrepresentation cases, and insolvency.
Contact Ammar on 02072752592 or at ammars@duncanlewis.com


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